The Tax Cuts and Jobs Act lowered the corporate income tax from a maximum rate of 35% to a flat rate of 21% beginning in 2018. However, business income from pass-throughs and sole proprietorships, which are taxed at individual rates, could still be taxed as high as 37%. To address this issue, TCJA created new Section 199A (effective 2018-2025) which provides for a 20% deduction from qualified business income (QBI) from pass-through entities and proprietorships to noncorporate entities, including individuals, estates, and non-grantor trusts. This creates an effective top rate of 29.6%. QBI does not include most investment income or capital gains, guaranteed payments to partners, and wages received as an employee. Also, QBI does not include non-U.S. source income.
In general, the deduction is equal to 20% of qualified business income (including qualified cooperative dividends), limited to 20% of the taxpayer’s taxable income (net of capital gains), as long as taxable income does not exceed $315,000 for joint filers and $157,500 for all others. If taxable income is greater than $415,000 for joint filers ($207,500 for all others), the deduction is also limited by the greater of (1) 50% of W-2 wages paid (based on the allocable share of wages of a partner or S corporate shareholder) or (2) 25% of W-2 wages plus 2½% of (allocable) unadjusted basis of depreciable property immediately after acquisition which is used in producing the qualified business income. The second limitation is to account for businesses that are more capital intensive such as real estate trade or businesses (currently, the law here does not distinguish between passive and active trade or business income). The above limitations are phased in when taxable income is between $315,000 and $415,000 for joint filers ($157,500 and $207,500 for others). In addition to the above, the deduction includes 20% of the aggregate amount of qualified REIT dividends and qualified publicly traded partnership income.
The QBI deduction does not apply to “specified service” trade or business income (think professional services) such as those involved in consulting, law, and accounting. A carve-out was provided, however, to allow the deduction if taxable income was below the $157,500/$315,000 levels, with a partial allowance up to a taxable income of $207,500/$415,000. Above these top thresholds of taxable income, no QBI deduction is allowed.
For example, if Rachel is married filing a joint return and has $250K of QBI from her law practice and $300K of taxable income, her QBI deduction would be $50,000. If her taxable income were $420,000, her QBI deduction would be zero. In this example, Rachel needs to lower her taxable income and should consider, e.g. fully funding a retirement plan, increasing charitable contributions, or even hiring an employee if needed, in an effort to get taxable income below the $415K threshold.
The potential tax savings of the QBI deduction raises the question of choice of entity. Should an LLC incorporate and elect S status and start taking wages in order to create a wage base that may not exist since LLC members don’t take salaries? If so, will this pass IRS scrutiny as to the payment of reasonable compensation to owners? Likewise, other S status rules would have to be considered, such as who can own S corporate shares, the number of potential shareholders and the one-class-of-stock rule.
The classic comparison for nonspecified service businesses is whether to operate as an LLC and possibly get a QBI deduction, or operate as a C corporation and pay the lower 21% flat tax. That decision will generally turn on whether the C corporation will regularly distribute its after-tax profit as a dividend, causing double taxation. If this is the case, the QBI deduction available as an LLC will generally produce the lower overall tax.
Part 2 of my blog will address other choice-of-entity comparisons, unanswered questions of the new law, practical considerations, and caveats. Stay tuned.
If you have questions or want further information on the above or other income, retirement or estate planning techniques, please contact Jordon Rosen at firstname.lastname@example.org.